Without The ‘Hot’ Ingredients The Salsa Would Be Flat

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Summary

My core portfolio – the Durable Income Portfolio – has returned 11.9%.

We consider diversification to be critical to the investing process.

When you examine these non-SWANs below, you can see why SALSA is the truly the spice of life.

I just finished content for the December edition of the Forbes Real Estate Investor (newsletter) and I am excited to release the year-to-date performance results. Specifically, my core portfolio – the Durable Income Portfolio – has returned 11.9%.

A majority of the REITs held in my Durable Income Portfolio are sleep well at night (aka SWANs) REITs that have demonstrated a successful record of risk management. Some of the best performing SWANS include names like Digital Realty (DLR) +23% YTD, W.P. Carey (WPC) +27% YTD, and STAG Industrial (STAG) +25.7% YTD.

However, there’s a reason that I don’t exclude REITs that aren’t SWANs… As Dr. Craig L. Israelsen explains,

“Great salsa is all about diversification. Only by adding diverse ingredients together can we achieve the desired outcome. However, there are some ingredients in salsa that most of us would never want to eat individually, like hot peppers or Tabasco sauce. But, without the “hot” ingredients the salsa would be flat.”

That’s exactly write, if I had excluded the non-SWANs within the Durable Income Portfolio, the performance would have been just 1.5% (equal weight). As Israelsen explains, “each investment asset adds an important dimension to the portfolio because each asset behaves differently. This diversity is vitally important in salsa … and in portfolios.”

When you examine these non-SWANs below, you can see why SALSA is the truly the spice of life:

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Similar to construct a REIT portfolio, investment portfolios should include a wide variety of diverse ingredients or “assets”. Israelsen adds,

“Mutual funds that invest in US stocks are a core ingredient for a portfolio, analogous to tomatoes in salsa. But, US stocks are only one asset class. More asset classes are needed. We need non-US stock. But, even after adding non-US stock, our portfolio still only has “stock” ingredients. We need diversifying ingredients such as bonds, real estate and commodities.”

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Way back when, there were two dominant investment categories (or asset classes), namely US stock and US bonds. These two assets became the mainstay ingredients in balanced mutual funds, with the typical ratio being a 60% allocation to large US stocks and a 40% allocation to bonds. Israelsenexplains,

“News flash, it’s not 1959 anymore.”

He explains that “a multi-asset balanced portfolio brings a higher standard to the notion of “balanced”. This new age balanced portfolio is known as the “7Twelve® Portfolio”. The name makes reference to “7” core asset classes with “Twelve” underlying mutual funds.

The 7Twelve Portfolio is constructed to generally follow the time-tested 60/40 guideline, but uses eight funds (instead of one) to create an overall equity exposure of about 65% and 4 fixed income funds (instead of one) to create a “bond” exposure of about 35%.

All 12 ingredients are equally weighted (each representing 8.33% of the 7Twelve Balanced Portfolio). The equal-weighting is maintained by periodic rebalancing (annual rebalancing is recommended).

The fundamental (or core) concept behind the 7Twelve portfolio has been tested over a 47-year period from 1970-2016 using 7 of the 12 sub-assets: Large US equity, Small US equity, Non-US equity, Bonds, Cash, REITs, and Commodities. (These 7 sub-assets have performance histories back to 1970, whereas not all of the components in the 7Twelve do). Each sub-asset was equally weighted in the portfolio (14.3%) and annually rebalanced at the start of each year. Taxes and inflation were not taken into account.

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As you see in the above chart, REITs have historically delivered competitive total returns, based on high, steady dividend income and long-term capital appreciation. Their comparatively low correlation with other assets also makes them an excellent portfolio diversifier that can help reduce overall portfolio risk and increase returns. These are the characteristics of real estate investment.

Why should I invest in REITs?

REITs are total return investments. They typically provide high dividends plus the potential for moderate, long-term capital appreciation. Long-term total returns of REIT stocks tend to be similar to those of value stocks and more than the returns of lower risk bonds.

Because of the strong dividend income REITs provide, they are an important investment both for retirement savers and for retirees who require a continuing income stream to meet their living expenses. REITs dividends are substantial because they are required to distribute at least 90% of their taxable income to their shareholders annually.

Their dividends are fueled by the stable stream of contractual rents paid by the tenants of their properties. The relatively low correlation of listed REIT stock returns with the returns of other equities and fixed-income investments also makes REITs a good portfolio diversifier.

REIT returns tend to “zig” when those of other investments “zag,” helping to reduce a portfolio’s overall volatility and improve its returns for a given level of risk.

Currently more than 70 million Americans are invested in REITs directly or through REIT mutual funds or exchange-traded funds (ETFs). In addition, institutional investors like pension funds, endowments, foundations, insurance companies and bank trust departments invest in REITs.

REITs are an important part of the economy, investors’ portfolio and local communities. Taken individually, a single REIT-owned property can change the entire complexion of a neighborhood. When viewed as an entire industry, REITs significantly contribute to the tax base, job market and community.

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REITs own and finance a broad and diverse array of real estate across the United States. The economic and investment reach of those assets are felt by millions of Americans all across the country.

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Since their creation in 1960, REITs have grown in size, impact and market acceptance. The creation of headline real estate sectors – populated mainly by REITs – in leading industry classification standards underscores the growing importance of REIT-based real estate investment in the equities marketplace.

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Nearly six decades after their creation, the U.S. REIT industry has grown to a $1 trillion equity market capitalization representing nearly $2 trillion in gross real estate assets. That growth led, in part, to the creation of the new Real Estate headline sector in the Global Industry Classification Standard in 2016.

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Where are we in the Real Estate Cycle?

By Calvin Schnure, SVP, Research & Economic Analysis, NAREIT
May 2017

Throughout the first quarter of 2017, media headlines contained several reports of economic weakness. Reports highlighted that GDP growth slowed sharply to 0.7%, the weakest in three years. Job growth stumbled as well, with nonfarm payroll employment rising an average 175,000 per month from January through March, well below the 220,000 monthly average over the prior three years.

Real estate markets were not immune to this weakness in macro fundamentals. According to CoStar, demand for commercial real estate slowed in the first quarter for all major property types except multifamily. Together with the new supply coming on the market, the soft demand caused vacancies to edge up (see chart below). Rent growth slowed as well.

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If there has been any theme to the economic recovery over the past eight years, it has been “two steps forward, one step back.” More important is that the move following the “step back” is generally forward again.

For example, first quarter GDP growth was one percentage point below the trend over the prior two years. Since 1980, shortfalls of this magnitude or greater have occurred more than 30% of the time. Growth rebounded to an above-trend pace in the subsequent quarter, however, nearly half the times when this occurred.

Real estate markets show a similar pattern. According to data from CoStar, the quarterly growth of demand for office, retail, industrial and multifamily properties fell by 25% or more nearly one-fourth of the periods since 1980. Demand rebounded in the subsequent period two-thirds of the time, however, and often rose back above the preceding quarter’s peak.

Keeping in mind how often these short-term fluctuations occur, the medium-term outlook for the macroeconomy, real estate and REITs remains positive. That’s because economic expansions don’t die of old age, they end if they overheat, are overbuilt or overleveraged. None of these terminal conditions, however, is present today.

Let’s look in turn at the macro fundamentals, conditions in commercial real estate markets and the latest performance data on REITs.

GDP and macroeconomic fundamentals

Warning signs, which include markets being overbuilt, overheated and overleveraged, are not present in the macroeconomy. The below provides an in-depth look at each of the warning signs:

Overbuilt? No. An overbuilt economy displays elevated cyclical components of GDP, including consumer spending on durable goods like autos, furniture and appliances, as well as construction of both residential and commercial real estate, and business investment. In the first quarter of this year, however, cyclical GDP was 24.1% of total GDP, some 1.5 percentage points below its long-run average (see chart below)

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This is not a picture of an economy that is overbuilt.

Overheated? No. Rapidly rising wages and prices can signal an overheating economy, which in past cycles typically prompted the Federal Reserve to seek to slow it down. Inflation, however, is still running at or below the Fed’s 2% target, with core inflation (as measured by the core personal consumption expenditures deflator, which strips out the volatile food and energy components) up 1.6% over the past year.

It is worth noting that the Federal Reserve has begun moving short-term interest rates higher. Fed officials have stressed, though, they are not trying to slow the economy, but rather “taking the foot off the accelerator” as the economy approaches its potential. Indeed, moving monetary policy from a stimulative stance to a more neutral one is designed to help prevent any overheating in the medium-term future.

Overleveraged? No.  Over the past eight years, most sectors of the U.S. economy have deleveraged and paid down debt. The Fed’s Financial Obligations Ratio (a version of the debt burden that accounts for consumer leases) shows debt payments at 15.4% of disposable income in 2016 Q4.

This is down from a peak at greater than 18% on the cusp of the financial crisis, and is at its lowest level since 1981. Banks have reduced leverage and raised their capital ratios as well, with an average core capital ratio of 9.5% in the fourth quarter, according to the FDIC, compared to a core capital ratio of 8.0% in 2007.

Commercial Real Estate

Commercial real estate markets are not displaying late-cycle indicators, either:

Overbuilt? No. No. Construction has ramped steadily upwards over the past six years from the trough reached in early 2011. This mainly reflects how much activity had slowed during the crisis. A longer perspective shows that construction activity, measured as a percentage of GDP, is still below the long-run average from 1993 to 2008. Furthermore, construction only recently rose above the lowest point it had reached during the prior two decades (see chart below).

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Overheated? No. Price increases in commercial real estate are unsustainable if they continually exceed the growth of net operating income (NOI). A sustainable trend is when periods of rapid increases are followed by slowing back to, or below, the growth of NOI. Such a slowing is in fact underway in 2017.

Commercial property prices rose at a double-digit pace from 2010 through the middle of 2016, and are 18% above the pre-crisis peak, according to CoStar’s Commercial Repeat Sales Index (see chart below). Price growth has flattened out so far in 2017. As long as the macroeconomy remains sound and contributes to rising rents and NOI, a slowing like this is a healthy development.

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Rising property prices have, however, pushed cap rates to low levels, and they would have moved lower still had there not been steady NOI growth. These low cap rates should not be surprising in a low-yield environment. The spread between cap rates and the yield on Treasury securities is wider than it had been during the entire prior decade, even with the recent back-up in interest rates (see chart below).

This spread represents the return over risk-free rates that investors receive for their positions in commercial real estate. Unlike the razor-thin margins experienced during 2006-2007, current cap rate spreads include an ample cushion for commercial real estate prices.

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Overleveraged? No. Lenders have been cautious about exposures to real estate, and the growth of commercial mortgage debt has been subdued. Bank lending has been restrained, and the CMBS market has been focused on refinancing the wall of maturities of loans originated a decade ago.

As a result, according to the Fed’s Financial Accounts of the United States , the growth of total commercial mortgage debt outstanding has leveled off at around 5% annually, one-third the rate of growth witnessed during the past two business cycles (see chart below).

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The latest data on operating performance of REITs from the NAREIT T-Tracker® reflect the slowing in the rest of the economy in the first quarter of 2017, as evidenced by 3.9% decline in funds from operations (FFO) (see chart below).

The slowing was concentrated in a few sectors, including Retail, Diversified, Self-storage and Data Centers. FFO in other sectors, in contrast, increased in the first quarter. Like the overall economy, however, the decline in total FFO represents one step backward after several steps forward in recent quarters, and total FFO was 8.1% higher than it had been one year earlier.

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Fundamentals in the REIT sector remain solid. The weighted average occupancy rate of REIT-owned properties stood at 93.9% in the first quarter, a record high since 2000 (see chart below). Additionally, high occupancy rates are paying off in rising income from commercial properties, with same store NOI up 3.7% over the same quarter one year ago (see chart below).

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The Trump Factor

I just released my newly updated edition of The Trump Factor: Unlocking The Secrets Behind The Trump Empire. In this Presidential Edition I explain,

“As any investor will tell you, the road to riches is not always the easiest, and there will always be bumps along the way.”

Similarly, we must all recognize that economic activity rarely proceeds in a straight line, and it is common for growth to fluctuate above and below trend through a long cycle.

The commercial real estate sector has experienced a five-year period where growth of demand exceeded new construction quarter after quarter, often by a significant amount. In the first quarter, demand and supply were roughly balanced.

This may feel soft following a long run where demand consistently outpaced supply. But with few signs that the economy is overbuilt and with the economic fundamentals for real estate still solid, the outlook for REITs and real estate is positive.

I consider Tax Reform to be a significant catalyst for REIT investors, especially when you consider the potential for wage and job growth.

From the beginning, President Trump made it clear that tax reform efforts would be focused toward providing relief for hardworking, everyday Americans. The current tax structure encourages businesses to invest overseas where tax rates are more competitive. By contrast, the GOP tax plans encourage businesses to bring factories, jobs and profits home, increasing demand for American workers and driving up wages.

The U.S. economy grew faster than initially thought in the third quarter, notching its quickest pace in three years, buoyed by robust business spending on equipment and an accumulation of inventories.

Gross domestic product expanded at a 3.3% annual rate last quarter also boosted by a rebound in government investment, the Commerce Department said in its second GDP estimate on Wednesday. That was the fastest pace since the third quarter of 2014 and a pickup from the second quarter’s 3.1% rate.

The economy was previously reported to have grown at a 3.0% pace in the July-September period. It was the first time since 2014 that the economy experienced growth of 3% or more for two straight quarters.

Now-casting.com‘s estimates a big bump in GDP in Q4017 to 4.6%, based on the firm’s Nov. 24 econometric analysis.

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In closing, we consider diversification to be critical to the investing process, and as part of the Intelligent REIT Investor service on Seeking Alpha, we provide subscribers with the best strategies for balancing risk and return. By employing diversification correctly, investors can reduce risk without sacrificing returns, our Durable Income Portfolio is a perfect example of that!

Always remember, without the ‘hot’ ingredients, the SALSA would be flat…

Happy Holidays

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Rationale of the 7Twelve® Concept

NAREIT

 

 

 

 

 

 

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

iREIT Investor

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